The WSJ Takes on the P/E Ratio

The Wall Street Journal has a rather unusual column today claiming that the Price/Earnings Ratio is not only declining, but the metric’s importance is declining as well. For supporting evidence, they offer up the fact that corporate earnings were strong this past earnings season but the stock market has since fallen.
Sorry folks but that’s not a hard knot to entangle: The P/E Ratio looks backward while stock prices look forward. As a result, you can get some poor readings. I’m afraid to tell the WSJ that despite this minor conflict, the P/E Ratio remains very important (though we must be aware of its shortcomings).
The WSJ goes on to say that the P/E Ratio has plunged about 36% in the past 12 months which is the biggest drop in seven years. Again, this shouldn’t be much of a surprise because, as I just mentioned, the P/E Ratio looks backward. Corporate earnings have improved very dramatically since the depths of the recession. A higher E with a flat-to-lower P means a lower P/E Ratio. Mystery solved.
The WSJ also writes that the forward P/E Ratio has dropped from 14.4 in May to 12.2 currently. This probably means that stock prices are ahead of analysts’ forecast and that those projections may be headed lower soon.
Because of the time discrepancy in the P/E Ratio we sometimes get “false readings.” For example, when stocks are cheapest, the earnings line is often still headed lower. As a result, the very first stages of a bull market often shows the P/E Ratio dramatically expanding. The opposite happens when the market begins to look rich, which may be happening right now. Stocks are sluggish while earnings have improved. As a result, you have stocks falling after good earnings combined with a subdued P/E Ratio.

Three months ago, analysts expected the companies in the Standard & Poor’s 500-stock index to boost profits 18% in 2011. Now, they predict 15%. Mutual-fund, hedge-fund and other money managers put the increase at closer to 9%, according to a recent Citigroup survey, while Mr. Levkovich’s estimate is for 7% growth.
“The sustainability of earnings is in doubt,” said Howard Silverblatt, an index analyst at S&P in New York. “Estimates are still optimistic.”

The WSJ says that the P/E Ratio is plagued by the lack of certainty in future earnings, and on this point I agree. Think of it this way. Imagine we have two stocks that are similar in every way except for one difference. Stock A is projected to earn $1 a share next year, plus or minus 20 cents. Stock B is projected to earn $1 a share next year, plus or minus three cents. Which stock will be worth more? Outside of rare exceptions, we can assume that Stock B will be worth more. Why? Because the market rewards certainty.
The WSJ also claims that the P/E Ratio has had earlier bouts of loss of importance — from the Great Depression to the early post-war period and again during the inflation struggles of the 1970s and early 80s. I agree on the former, but the latter was hardly a refutation of the P/E Ratio. It’s simply that the P/E is closely tied to interest rates. As rates head higher, P/E Ratios headed lower so stocks could actively compete with bonds.
I can assure you that any obituary for the P/E Ratio is very premature.

Posted by on August 30th, 2010 at 2:43 pm

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